Growth, Inflation and Capital Flows in a Multi-Speed Global Economy

Low growth, high unemployment and heavy debt burdens plague the economies of many developed nations. Despite massive amounts of monetary and fiscal stimulus, long-term bond yields are being driven lower as sub-par growth and the specter of price disinflation — even outright deflation — is the near-term concern. To contrast, in emerging Asia GDP growth is rising, intra-Asian trade is booming and central banks are tightening monetary policy to restrain rising inflationary pressures. Within this dichotomy lie the seeds of a much-needed global rebalancing. (See Figure 1)

FIGURE 1

In response to slack economic conditions, monetary policy in the developed world is exceptionally loose. In the U.S., for example, the stimulus taps have been turned wide open. Interest rates are near zero and the Fed's balance sheet has ballooned dramatically in an effort to flood the economy with cash. Yet, despite this overwhelming stimulus, the U.S. economy remains mired in sub-par growth, consumers are reluctant to spend and core inflation at 0.9 percent remains below the Fed's comfort zone.

This low growth, low inflation environment is not unique to the U.S. In the euro-zone, benchmark interest rates are also low and the ECB has reaffirmed a broader commitment to ultra-loose monetary policy. Irrespective of this accommodative stance, the increasing pressure that policy makers face to reduce spending and cut deficits is likely to drag on growth, setting the stage for lower prices in the near term. Indeed, Ireland, facing a wrenching fiscal retrenchment, has already experienced some degree of price deflation. Despite higher growth and some signs of wage price inflation in Germany, growth and core inflation are likely to remain low across the euro-zone. Likewise, in the U.K., although recent headline inflation numbers have been above the Bank of England's (BoE) target, the bank expects inflationary forces to recede and economic growth to be restrained in the future.

The possible dangers ahead for these developed economies are an all-too painful reality for Japan, where lackluster domestic demand and falling prices have haunted the economy for years. While markets fret about a bond bubble as yields in the U.S., Germany and the U.K. continue to grind lower, investors in Japanese government bonds have experienced just how low yields can go in a low growth, deflationary environment. (See Figure 2)

FIGURE 2

Given this relatively stagnant outlook in much of the developed world, it is not surprising that capital has been once again flooding into emerging markets in search of higher returns. As noted in Figure One, the International Monetary Fund (IMF) estimates that emerging Asia alone will experience GDP growth of 9.2 percent in 2010 vs. 2.6 percent in advanced economies. Inflationary pressures have been building in concert (See Figure 3) and many central banks across the region, including India, Thailand, Vietnam, Singapore and Malaysia, have already begun tightening monetary policy.

FIGURE 3

While policy makers in emerging Asia have been relatively vigilant about capping inflationary pressures, higher interest rates here present a paradox of their own: in a global economy besieged by the ultra-low rates of developed countries, capital is likely to flow quickly in search of higher returns, sending local currencies soaring, potentially destabilizing these smaller export-oriented economies.

The situation is more acute when one considers that most of emerging Asia has ties to China as either a key export destination or direct competitor. Despite its recent move to de-peg the renminbi, the Chinese currency is essentially little changed, reflecting the ultra-loose monetary policy of the U.S. and other developed nations. Policy makers in emerging Asia would be loathe to increase interest rates, prompting a rise in their local currencies, only to see economic growth plummet as China exploits an undervalued yuan. Further complicating matters, while intra-Asian trade is indeed booming, it is estimated that the final destination for much of this activity includes the U.S. and Northern Europe. Thus, absent an increase in domestic demand, the region still remains vulnerable to a slowdown in the broader global economic environment.

Clearly, tighter monetary policy and stronger currencies in emerging Asia would be more palatable if China's renminbi were to strengthen meaningfully as well. Although arguably not the panacea that U.S. lawmakers would like their constituents to believe, this is necessarily one small part of a broader global rebalancing that will help sustain domestic demand growth in emerging economies and relieve the disinflationary forces stalking more developed nations. The road to such a rebalancing, however, is likely to be long, fraught with pitfalls and may result in slower growth for many emerging economies as the process unfolds.

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Low growth, high unemployment and heavy debt burdens plague the economies of many developed nations. Despite massive amounts of monetary and fiscal stimulus, long-term bond yields are being driven lower as sub-par growth and the specter of price disinflation — even outright deflation — is the near-term concern. To contrast, in emerging Asia GDP growth is rising, intra-Asian trade is booming and central banks are tightening monetary policy to restrain rising inflationary pressures. Within this dichotomy lie the seeds of a much-needed global rebalancing. (See Figure 1)

FIGURE 1

In response to slack economic conditions, monetary policy in the developed world is exceptionally loose. In the U.S., for example, the stimulus taps have been turned wide open. Interest rates are near zero and the Fed's balance sheet has ballooned dramatically in an effort to flood the economy with cash. Yet, despite this overwhelming stimulus, the U.S. economy remains mired in sub-par growth, consumers are reluctant to spend and core inflation at 0.9 percent remains below the Fed's comfort zone.

This low growth, low inflation environment is not unique to the U.S. In...Read More